September 18, 2012 was a noteworthy day for students of history.
King Juan Carlos of Spain stepped into the political fray for the first time in more than 30 years, calling on all Spaniards to stick together during the hard times in front of them and to avoid chasing unrealistic pipedreams (those who can read Spanish can view his letter here).
The King’s comments were his most direct involvement in Spanish politics since he intervened in 1981 to prevent a mad, machine-gun-toting colonel from taking over the government.
Today, no one is walking into Spain’s parliament building and spraying the ceiling with bullets, but the King’s letter is telling. Spain—and much of the rest of peripheral Europe—is mired in a cycle of debt-necessitated austerity and economic contraction that has created the worst crisis in decades. Europe is a mess.
For all of the optimism surrounding Mario Draghi’s “Big Bazooka” moves to stabilize the Eurozone through outright monetary transactions, the crisis still has a long way to go before it is resolved.
And I should be clear—it may never get resolved.
Depending on the political decisions made over the next 3 – 6 months, the Eurozone could emerge from the crisis as a stronger, more durable union. Or, the entire European project—which has been in the works for sixty years now—could come apart at the seams.
With all of this as an intro, you might be surprised by what I say next: I’m bullish on European equities and maintain an overweight position in them in most of my client portfolios.
Let’s look at some of the bullish arguments:
- The ECB doing “whatever it takes” via unprecedented monetary stimulus – All investors have heard the standard advice: Don’t fight the Fed. I would argue that, for the first time, the same can be said of the European Central Bank. Mario Draghi broke long-standing taboos and asserted his authority over the German Bundesbank by launching his program of potentially unlimited outright monetary transactions over the objection of Bundesbank President Jens Weidmann. Draghi has a bigger bankroll than you, and he’s shown that he’s not afraid to use it, even if it means stretching his constitutional mandate. This does not by any means suggest that Draghi can create the conditions for a durable bull market; but it does mean that he can stoke the flames of a multi-month rally.
- The bailout mechanisms will clear up the uncertainty weighing on the market – Spain has yet to formally request aid from the ECB or the bailout institutions; yet rumors that prime minster Mariano Rajoy was getting close to doing so was enough to send Spanish stock prices soaring last week. According to leaked news from the parties involved, EU and Spanish officials are working behind the scenes to set out the conditions for a Spanish bailout that Rajoy would accept. Meanwhile, Der Spiegel reports that talks are underway to allow the Eurozone’s primary bailout fund—the European Stability Mechanism—to be leveraged to 2 trillion Euros if need be. Suffice it to say, a lot of monetary firepower is being thrown at the Eurozone, and a fair bit of it can be expected to find its way into the Eurozone equity markets.
- European stocks are the cheapest in the world – Finally—and most importantly—European stocks are dirt cheap relative to their world peers. To be sure, some sort of “Europe discount” is appropriate given the macro risk and the unappealing growth prospects for years to come. But at some point, the stocks are simply too cheap to ignore. By FT estimates, the French, German and Spanish markets trade for just 14.1, 12.7, and 13.4 times earnings, respectively. Depressed earnings, I might add. Each also yields between 3 and 5 percent in dividends. Compare this to the United States, which trades for 16.1 times cyclically-high earnings and yields a pitiful 2.1%. Are European stocks as attractively priced as they were two months ago? Of course not. But I still expect them to be among the best performing in the world over the next 6-12 months.
It’s only fair to mention the other side of the coin. If the bond market loses faith in Mr. Draghi or infighting among Europe’s politicians prevent them from making the institutional reforms needed to make the bailouts credible, then all bets are off. (Just today it was announced that the German, Finnish and Dutch finance ministers had announced opposition to aspects of the bank bailout….sigh). In the event that the reforms truly break down, investors will want to not only exit their European equity positions but exit all risky assets, as this would mean a return to the risk-on / risk-off volatility we’ve had to endure for much of the past two years.
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